Julian Morrison explains why emotional comfort will lose money for investors.
Contrarian investors are prepared to think and act differently to ‘conventional’ thinkers.
Being contrarian does not mean being smarter than conventional investors, having better information, or more sophisticated systems to process that information.
Rather, contrarian investing places greater emphasis on acknowledging the influence of human emotions and behaviours on financial markets and embracing this to one’s advantage.
Finance theory assumes investors are perfectly rational – experience shows otherwise. Standard finance theory assumes investors are always perfectly rational and that markets are always efficient.
Experience has proven that markets are not always efficient, and developments in ‘behavioural finance’ demonstrate that investors do not always make decisions within a perfectly rational economic framework.
Behavioural finance uses social, cognitive and emotional factors to understand individual and institutional economic decisions and their effects on market prices.
Contrarian investing is therefore closely linked to behavioural finance.
For example, investors are often driven by what feels most comfortable and consistent with their personal beliefs, rather than financial precision.
A comfortable decision and a financially rational decision are not always the same thing. Contrarian investors acknowledge their emotions when making investment decisions.
They argue that the most comfortable decisions are rarely optimal from an investment perspective.
More specifically, some of the best investment opportunities are those that the consensus views as imprudent.
Conversely, opportunities held in the highest regard by the consensus are sometimes amongst the most risky.
Contrarian investors look at the same situation through a different lens. To understand how contrarian investors interpret a situation differently, consider the following scenario.
In the pursuit of growth by acquisition, company XYZ runs into trouble.
It is clear that management has overpaid for additional businesses it has bought. It has also taken on more debt to finance these acquisitions, making the company more vulnerable to unfavourable conditions.
As their industry comes into harder times, to survive they had to raise equity on several occasions, diluting shareholders’ interest.
The originally strong core of the company has been compromised by management overreaching for growth. Value has been destroyed.
The management is eventually fired, but tough times seem set to continue, and the new management has a daunting task ahead.
To most people, contrarian investing may feel more risky than investing in the most popular companies. With popular companies, current news tends to be strongly positive and makes investors feel comfortable.
The problem with investing in a popular company that everyone likes is there will be many other keen buyers, and few willing sellers. This puts the sellers in a stronger position, and no-one is going to sell to you at bargain prices.
It is also likely that no-one will even sell it to you at a reasonable price. Why should they?
They may have made some unrealised profit so far, things are going great and they would feel huge regret if they sold out and missed further gains. They will make you pay up if you really want to buy their shares.
Quite simply, the price paid can be the difference between a great investment and a terrible investment.
Unpopular means bargain
On the other hand, if you look at a less popular, more contrarian company, there will likely be more eager sellers and less competition amongst buyers.
This is where you are most likely to achieve a margin of safety by buying the shares at a cheap price.
Given the low competition amongst buyers, you can decide the price you are prepared to pay and let the sellers come to you.
If your thesis is correct, the company’s future doesn’t need to be extraordinary to result in impressive gains in the share price, as the consensus adjusts – from a negative view, towards a more neutral view.
As business fundamentals normalise, more buyers give you an opportunity to sell. If the company normalises to a more positive footing, new buyers may eventually begin to outnumber willing sellers.
As the share starts to become a more comfortable investment for the conventional investor, competition amongst buyers increases, and at some point, the share price may venture above a reasonable valuation.
If you choose to sell at this point (as a contrarian will tend to do) you can put in your ‘offer’ price, and once again let the market come to you.
You will likely be selling to an investor seeking the comfort of a (now) more popular company that is enjoying more positive news flow.
There are a variety of contrarian opportunities that investors can exploit. These include opportunities in companies that are:
- Disliked, hated, vilified;
- Not researched and therefore not promoted by brokers;
- Considered to be too small by large institutional investors; and
- Companies that are not in currently ‘hot’ or favoured sectors.
The common theme is that they are not popular, and therefore there is less competition amongst buyers.
Unpopular seems riskier
Because a ‘contrarian portfolio’ features unpopular shares that are linked with negative news (or no news), the contrarian portfolio may look and feel more risky than a ‘conventional’ portfolio.
In contrast, the conventional portfolio contains popular shares with positive news flow. So the conventional portfolio looks and feels safer, more familiar and less risky.
Favouring the conventional portfolio is natural and predictable human behaviour, but doing so can invite nasty surprises.
With the contrarian portfolio you are paying a lower price to take on recognised risks, while with the conventional portfolio you are enthusiastically paying a higher price (for a positive story) but taking on largely unrecognised risks.
Contrarian investors avoid extrapolating recent bad news in perpetuity
Where negative influences weigh on the price of an unpopular share, the contrarian investor does not disagree that these factors exist. Rather, they avoid automatically extrapolating the recent bad news in perpetuity.
They prefer instead to calmly assess the company’s ability to generate a profit into the future. They also assess the extent to which the market is disregarding this and placing too much weight on the recent past.
This is central to the contrarian thesis of what makes an investment good or bad.
In this way, a contrarian investor purposefully seeks to accept recognised risks which have already been excessively priced in – to the point where price is significantly below intrinsic value, and prospective return is high.
Conventional investors assume unrecognised risks
In contrast, a ‘conventional’ investor seeks to feel comfortable by holding companies that are currently popular.
But in return for that feeling of comfort, they are more likely to take on unrecognised risks which have not yet been reflected in an inflated share price. Positive developments will be less of a surprise for these companies.
Negative developments, on the other hand, can be a far bigger, nastier surprise than most investors have even entertained as a possible outcome.
So the underlying principle of contrarian investing is that it can uncover some of the most attractive investments — which offer not only higher than average prospective returns, but also lower than average risk.
This is counterintuitive to most investors, which is why the majority take a more emotionally comfortable path.
The diagram and table show some of the key features of a contrarian view.
Long-term investment success requires humility, discipline and focus
Perhaps the biggest risk for the contrarian investor is the risk of becoming too comfortable with the uncomfortable.
Being successful requires maintaining a balance – on the one hand, to have ‘against the grain’ thinking flow naturally.
On the other, to have respect for the market and not simply assume the market is wrong – often it is not. To be successful over the long-term requires humility and a conscious avoidance of complacency and hubris.
It is important to remain unbiased and open-minded with each investment opportunity you consider.
It can help to ask the following questions:
1. Why does someone smart and well informed want to sell me this share at what looks like a cheap price? If I cannot answer this clearly, perhaps I do not understand this situation and should not invest.
2. If I understand the reasons why this share is cheap, do I have a realistic expectation of the risk of impairment to the underlying business – both the likelihood and potential magnitude? This will affect the price I am willing to pay, and the size of the position that I take.
3. If for some reason I were unable to sell out of this position for many years, would I be happy to be a long-term owner of the company? My answer should be based on a thorough understanding of how the business will generate a return well into the future. If the answer is ‘no’, I should not invest.
4. If I choose to proceed, at what price am I comfortable buying equity in this business? Quite simply, the price I pay can be the difference between a great investment and a terrible investment. I must demand a large margin of safety to allow for error and uncertainty.
Avoid arrogance
Choosing to fish in the contrarian pool (rather than the popular pool) can significantly weigh the odds in your favour. That is the first hurdle.
However, the successful contrarian investor needs to keep an open mind with each new investment opportunity, and avoid the mistake of blinkered arrogance.
This is where it is important to apply independent, qualitative thinking rather than simply relying on quantitative selection of shares using valuation metrics.
Contrarian investors acknowledge the influence of human emotions and behaviours on financial markets, and embrace this.
They are willing and able to think differently to others, and act on this in a way that feels uncomfortable to many investors. For these reasons, it is not for everyone.
Ironically, it is the unpopular and uncomfortable that makes contrarian investing such a rewarding and sustainable strategy.
Julian Morrison is a relationship manager at Orbis Investments Australia.
